Do Tariffs Change the Economic Outlook? (With Phil Mackintosh)

LIZ ANN SONDERS: I'm Liz Ann Sonders.

KATHY JONES: And I'm Kathy Jones.

LIZ ANN: And this is On Investing, an original podcast from Charles Schwab. Each week, we analyze what's happening in the markets and discuss how it might affect your investments.

Hi, Kathy. So blissfully, every once in a while, we get a shortened week. Monday was a holiday, but clearly no shortage of news and things impacting the markets. So I want to toss to you first, somewhat specifically on trade policy and tariffs, but more broadly the impact on the dollar and the Treasury market and some of the concerns that I know you're hearing and we're hearing about whether we have something significant to worry about in terms of whether there might be some sort of buyer strike of Treasuries, foreign investment dwindling. So really open, broad, big question that I just tossed your way. But what are your thoughts?

KATHY: You're right, Liz Ann. A lot of people are understandably concerned because things are happening so quickly and without a lot of process to kind of understand. On the trade policy and tariffs, I think the good news is that it seems to be kind of a stop-start process so far. "I'm going to throw tariffs on so and so," and then, "Well, maybe we'll wait a little while." And so I think the market is rolling with it and saying, "OK, we're going to get some tariffs, but they seem to be more of a negotiating tactic than anything else." It may have a negative effect on economic growth. It's certainly going to harm certain parts of the economy, those that rely on foreign trade if they stay in place—that's going to be very, very difficult for certain industries. Certainly the agricultural community is feeling it already. But part of what they're feeling is the cutoff of aid that has already taken place. So the good news is the dollar's been strong, hanging in there, doing OK. And U.S. Treasury market, we've been stuck around 4.5% on the 10-year Treasury now for quite some time.

The Fed is on hold. So you're not really seeing a big market impact at this stage of the game. And I think that that's very good news, because I think what's happening is investors, both domestic and foreign, are kind of looking through all this noise and saying, "Well, so far it's more bark than bite. It's more noise than substance. We will have to see." And then there are concerns which are deeper and more concerning about "Will we live up to our obligations in terms of our debts and the Treasury market?" And there again, I would point to the fact that the market is not taking a lot of this seriously. And I think that that really reflects the kind of overall wisdom of the market and all the various investors saying, "Look, the U.S. is a very wealthy country with lots and lots in the way of assets."

We have the capacity to pay our debts. It's not the capacity that is the issue. It's the willingness. And so that's really what's on the table right now. Which things are we willing to keep funding and which aren't we? But the Treasury market, I think, recognizes that the U.S. has the capacity to service our debt. And, I think, very confident that that will continue.

You're also seeing it in the dollar. You know, the dollar stayed very firm. And I think that that's a reflection of the international market's view that, yeah, the U.S. is going to live up to its obligations. And it's still one of the strongest economies in the world. And doing quite well. Our interest rate differentials are keeping the dollar firm. And amid all the noise, maybe it's best to just kind of pay attention to the wisdom of the market at this stage of the game and say, "Yeah, there's a lot of stuff going on, a lot of uncertainty out there, probably going to affect both growth and inflation." So maybe push up inflation through tariffs, but a negative impact on growth. And the market's kind of looking at the balance of that and just staying range-bound. But the broader concerns about the budget and our willingness to pay, I think, are probably overblown and understandable, but something that we should probably just, you know, kind of put to the side and not let it affect our longer-term investing horizon. And the last thing I'll say is, you know, best defense is diversification, right? Just make sure you have lots of diversification in your portfolio. That's probably the best defense against all this uncertainty. I don't know, Liz Ann, what are your thoughts on that?

LIZ ANN: Well, you know, one of the things we espouse all the time is the benefits of diversification across and within asset classes, especially during more tumultuous times. Looking at the equity market, it's been interesting to see how it gets intertwined with some of the policy-related uncertainty. I think it's part of the reason why there's been a bit of a shift toward value with sectors like materials and financials actually leading on a year-to-date basis, and toward the bottom are some of the growthier sectors like consumer discretionary and even technology. Technology's had a little bit of a lift, but it's ranks toward the bottom. Much more dispersion in a group like the Magnificent Seven, with none of the seven in the top 10 best performers here today. In fact, Meta, which is the best performer among them, is ranked 19th, and the remaining six names are all in the bottom half of S&P performance. But as you and I are taping this just yesterday, we did see the S&P trading at an all-time high. But it's not solely a function of that small subset of stocks. There has been a broadening out. If you look at trailing one year, only about 20% of the S&P's constituents have outperformed the index itself. But over the past month, that's almost 50%.

So you're just seeing broader participation. Another interesting thing, and I think this will bring tariffs and trade into play more specifically, but a lot of studies recently done on the impact of macro-versus-micro on how stocks are behaving. And macro has actually been declining as a factor driving equity returns at the individual-stock level, whereas individual fundamentals have been more of a driver. You certainly saw that during earnings season with the misses really getting punished in the market, although the beats were not rewarded. They were also weak in terms of the first day after announcements, but really more significant punishment of the misses. You did see throughout the course of earnings season, which is coming to a close, a record mention of tariffs on earnings conference calls, even to a higher degree than the peak that we saw during the 2018 trade war. 

So it is filtering into concerns that corporate managements have. And to your point about inflation, I think we'll start to get into the psyche probably of consumers, too. We know and we talk often about inflation data as it comes in whether it's Consumer Price Index or Producer Price Index or Personal Consumption Expenditures. All of those are expressed in rate-of-change terms. We get the year-over-year reading. We get the month-over-month reading. I think what tariffs have the effect of probably doing is a price-level reset higher, certainly for those goods on which tariffs have been placed. It may not result in consistently higher rates of inflation, but that level shift up is important to consumers because quite frankly, that's how they think of inflation. You and I sit in the weeds of the rate-of-change in core versus headline and month-over-month and core services, ex-housing. But I think people in the real world think about inflation as "Stuff is more expensive than it was …" fill in the blank when, you know, pre-COVID or a year ago. So I think that will continue to be an important consideration. I think it is going to continue to filter into equity market behavior, sort of internal volatility and churn, even if you don't see it broadly at the index level.

KATHY: I would agree on the inflation view. And I would only note, too, that tariffs really akin to a tax, right? So it raises the price level at least one time when they're imposed. And unfortunately, it's a regressive tax, meaning it's much harder on lower-income folks than it is on higher-income folks, because especially now, some of the tariffs we're talking about are on basic things that we need for everyday life, and that just makes the divide wider. And makes it more acute for the average person out there to feel like inflation is much higher than the rate of change would tell us. So it is a contributing factor, I think, to that, definitely.

LIZ ANN: One other interesting thing that I read just in an article this morning is just about the ecosystem of trade in this backdrop of significant globalization over the past 25 years or so. And one example that was given is just the iPhone. And there are 50 countries involved in producing the iPhone, and not a single one, including China and the United States, could produce the iPhone on their own.

You can say the same thing for pharmaceuticals. You could say the same thing for automobiles, for semiconductor chips. So this is not an easy task if the goal is to bring production back to the United States. We're talking about a very complex trade ecosystem. And I think that sometimes gets lost in the analysis and the headlines.

KATHY: Yeah, I would agree. I love those maps. If you've ever seen them, those interactive maps that show you where something starts and where it goes and then where it ends up when it comes back. It's kind of a nice visualization of how trade works around the world. 

We have a very interesting guest this week and with a very interesting and unique job. Can you tell us about him?

LIZ ANN: Yeah. So it's Phil Mackintosh, and he's the chief economist and senior vice president at Nasdaq, and he manages Nasdaq's microeconomic research. And that encourages capital formation, increases investor returns through better market structure, but he talks about bringing the micro analysis up to a macro framework and view as well. So just coming at it in a bit of a different way than the traditional economist or market strategist. And we will link to this in the show notes, but he does have a weekly newsletter called Market Makers, and it covers topics ranging from IPO markets to exchange-traded-fund trading, retail investor activity, and a lot more. 

So Phil joined Nasdaq in 2018, bringing more than 30 years of financial, operational, and trading experience. He has held senior trading and research roles at KCG/Virtu Financial, Credit Suisse, and County Investment Management. Phil started his career at KPMG and is also a chartered accountant. 

So one other note about the interview. Like most weeks, we discuss things like PCE and CPI. I want to be clear that those stand for Personal Consumption Expenditures Price Index—that's the Fed's preferred measure of inflation—as well as the Consumer Price Index.

So Phil, again, thank you so much for joining us. I wanted to start with your role as chief economist obviously exists in traditional Wall Street firms everywhere, but maybe you could talk a little bit about that role inside the Nasdaq. Are there differences in how you approach the role relative to if you were at a firm, I don't know, like ours or one of the wirehouses?

PHIL MACKINTOSH: Yeah, I think it's probably really different, maybe even more different than you would expect because what we start doing is a lot of microeconomics. So we care a lot about having market makers on the bid and the offer of all the different stocks that we list, whether they're really liquid stocks that everybody's trading or really illiquid stocks that you never hear about, because that's actually important for companies to keep them trading, to keep their cost of capital lower. I mean, the whole point of public-listed markets is so companies can raise cash to go build factories, to go hire workers, to go innovate, but if they can't raise that cash cost effectively, they won't do it, and so the economy will slow down. So a lot of what we actually do is microeconomics, looking at trading, looking at markets, making sure that Nasdaq has the best quotes, the most liquidity, the best market on close with the least volatility. And from there, it's kind of been a natural extension for me at least to start to do macroeconomics because actually the customers trust that we get the microeconomics right, but they're more interested in the stuff that you're doing on a daily basis. 

They're more interested in tariffs and the macroeconomy and interest rates and unemployment and what they should be thinking about in the year forward. Should they be expanding? Should they be contracting? Should they be borrowing money or raising equity? And so I've kind of got both legs of the economic stool, if you like, a macro and the micro on a day-to-day basis.

LIZ ANN: Well, that's fascinating and also somewhat akin to what I do at Schwab. We don't have a chief economist, so I get to wear the hat of chief economist and chief market strategist. But I think that the arrow direction maybe is a little bit different given what you just described as starting with a base of micro and then having that feed up into a macro view, where I think about a role like mine as starting with the macro and then that ultimately feeds down to a slightly more micro level, and then from there, other folks inside Schwab get it to the actual stock level. So that's really interesting. 

And I want to get to some of the micro stuff because you have some interesting thoughts on markets, but let's start big picture with the macro outlook and maybe just set the stage in terms of your perspective on where we are in what I think everybody agrees is a very unique economic cycle in this post-pandemic kind of environment, and then also tie in the ultimate hot-button issue these days of tariffs. And maybe if you have thoughts on immigration, some of the policies coming out of the new administration, and the impact they are likely to have on where we are in the economic cycle.

PHIL: Yeah, I think where we are, like where we came into 2025, is actually in a really good place. If you're a central bank and you were trying to get full employment and low inflation, you're almost there on both fronts. I mean, we had a huge spike in inflation, so 7, 8% at the peaks, and it's all the way back down below 3%. The PCE inflation gauge, which the Fed prefers, is lower than the CPI, but they're both pretty close to that 2% target, given the scale of where we got to. So inflation's pretty much under control. Unemployment has ticked up a little bit. We saw that last year, but it's kind of holding at that 4, 4.1% level, which is historically, looking back decades, really full employment, like really low levels of unemployment. So actually, where we are from a central bank perspective is in a really good place. And if you look at the GDP around the world, the U.S.'s GDP growth has been stronger than almost any other developed market.

But we didn't really have recessions around the world. Even Europe, which is running much slower, it's seeing growth. And so I think where we're sitting right now is pretty close to goldilocks, really. It's like not too hot and it's not too cold. And I guess that's why interest rates have been coming down around the world, because the central banks don't need to tighten policy anymore. I think the interesting debate looking forward is whether interest rates will get down to a neutral rate where they're not contractionary. And if you look at Europe's forecast, I mean, their rates are down closer to 3%, and they're expected to get to nearly 2% later this year. With the rate of growth in their population, I think that's probably about where they should be. The U.S. market, like we've seen rates come down about a whole percent so far, and they were meant to keep coming down, so getting closer to 3% if we look back six months ago. But one of the things that's really changed, I guess since even prior to the election, but since the election, is the forward curve. So the longer-term expectations of the fed funds has gone up a lot, and so we're thinking now we might not even get down to 4% interest rates, and that's going to be important when you're talking to anyone who's borrowing money, and so we can talk about consumers with their debt, and we can talk about small-cap companies especially with their debt and how that's going to affect them.

LIZ ANN: And your perspective on tariffs, obviously this is a moving target on a daily basis and just simply the time between you and I taping this and when it airs, a lot can happen. So listeners, keep that in mind, but how are you incorporating that into your at least near-term thinking on what happens to the economy, especially given the healthy state of the economy, including employment at the start of the year?

PHIL: Yeah, so I think tariffs are going to be like at least a four-step evolution of news information. And to your point, we don't even really know what tariffs are going to be input for most of the countries, for most of the different goods and services at the moment. So I think first thing we're going to see is the tariffs that are put in place here. Then we're probably going to see retaliatory tariffs from other countries back to us. Then we're going to see companies that are trying to make sure that they can still sell products profitably changing their supply chain.

And what that might do at the end is actually create skill shortages or factory shortages or resource shortages in different countries. And so how that plays out is going to be kind of interesting. And we can draw a couple of parallels from things that have happened, I guess, in the first presidency of Trump and also during COVID. And so in the first presidency of Trump, remember, he put tariffs on China, and China turned around and said, "I'm going to put a retaliatory tariff on soybeans." And so the soybean farmers in America sold half as many soybeans as they'd planted, half as many as they used to sell. And that hasn't actually changed since that first implementation went in. 

Brazil has gained instead of us. So that's a classic example of where the people that need to buy soybeans will just try and work out where the next cheapest soybean is, and the supply chains will shift. And so if you think about how the supply chains have shifted, it hasn't been like really dramatic, all in one week, big bang. If you look at China, China's exports to the U.S., they've pretty much halved, but it's taken six years for that to happen. And the places that have won, maybe some manufacturing has come back to the U.S. Definitely there's more importing into the U.S. from countries like Taiwan and Korea and Vietnam that are close to China.

So maybe they're like value adding in those countries and still being able to export to us. There's been some gains in Mexico. So what we call near-shoring, and I spoke to companies back in 2018, and they were talking about like "I need cheap labor. Mexico still has it, so I can build a factory there." And so that's obviously happened over time. Europe benefited a little bit. I guess we could call that friend-shoring, where we have a better relationship with them and more trust in terms of intellectual capital and rule of law. And so they've gained a little bit during that six years. But again, it's been a slow evolution as companies work through their supply chain, try to keep their margins whole. 

I guess to answer your bigger question, "What's going to happen?" First, we don't really know because we don't know the first step, which is the tariffs or the retaliatory tariffs, but companies will adjust. And so the first, I guess, mathematical answer of how much tariffs will raise will end up being lower than people think.

The impact on inflation will end up being lower than people think because of that as well. There was a Fed study that came out looking at the 2018 tariffs, and it found no impact on inflation. It did seem to find an impact on GDP, so actual output, because technically one thing that happens when you force new countries to make things they weren't making before, maybe they're a little bit less efficient at doing it. Maybe there's less skill in the labor force, maybe they're just not as used to it, maybe you still have to build a factory, and so output levels can come down, and GDP can hurt.

LIZ ANN: Now, one follow-up question on that. You were right to point out that in terms of our importing relationship with China, that did change in the aftermath of the 2018 tariffs. However, and as you mentioned, other sources of production for us moving to, whether it was Vietnam, Cambodia, Indonesia, but also mentioning Mexico. But wasn't a decent chunk of that essentially just a rerouting, meaning it was still China producing something for consumption ultimately in the United States, just routed via those countries and increasingly Mexico. So the net of it from a global trade deficit perspective didn't change. It was just some shifting in terms of the ultimate destination for goods from China.

PHIL: It's quite possible if that's an easy way for a company to get around having to pay those tariffs because I guess the first thing is you put a tariff on a good, and it does increase the cost of bringing that part in or bringing the whole finished good into America. And as a company, you either have to pass that on completely to your consumers, or you have to pass on a piece of it, and then the balance you're going to have to eat yourself, which reduces your profit margins. And profit margins are what make stock prices go up. So companies want to hold their profit margins if they can. So I guess it's just a natural way of solving for the tariff problem is to try and work out "How do I restructure my supply chain?" even if it's as simple as what you're saying, which is let's just put things on a truck and cross a border and then put on a boat in another country. If that's what it takes, I guess that's what you'll do as a company because you're trying to minimize costs for the customer.

LIZ ANN: I want to get back to your comments on profit margins, because I think that's a very important topic as we think about the calendar year of 2025. But before doing that, one last, I may jump around a little, get back to another macro question. But for now, one last macro question as it relates to Fed policy. Obviously, the Fed would be considered in pause mode right now. And the Fed being data dependent means it's going to depend on the data as to what they do next. But to you, do you have an outlook on Fed policy this year, inclusive of how they're thinking about or incorporating in some of these policy related uncertainties?

PHIL: My team's not really structured to like have a forecast of what the Fed should be doing, but looking at things like demographics, I think the Fed should be cutting rates more than they say they're going to. Like we said at the outset, the inflation rate's pretty much back to 2%.

And the employment rate is ticking up, so I don't see really a lot of reason to stay restrictive, and if you look at the demographics around the world, there's only one continent in the world that's having enough babies to grow the population. So populations globally are shrinking, and what that means is the workforce is shrinking as well, and it's also aging in most countries. And an aging workforce … if I think about my parents, they're hanging onto their car longer. They're downsizing their house. It's totally different than if I think of my sister who's having babies and needing new houses for the kids to move into and buying wide goods and buying new clothes. Like, the amount of purchasing coming from a growing young economy is so much more than the amount of purchasing coming from an aging economy, and if the workforce is shrinking as well, it's quite possible that the level of output shrinks just because there's not as many workers. So I think there's massive headwinds coming from demographics.

I personally don't see the reason for the interest rates to stay more than probably 3%. So if we're to have inflation at 2.5% and coming down to 2%, a real interest rate of 1% is probably restrictive enough. And that's about what the Fed says the neutral interest rate is, too, is 3%. And when I'm talking to corporates, if we look at the interest expense coming through small companies in the U.S., it's about 50% of their EBIT, so their earnings before interest and tax.

That's a big chunk to take out of your profit margin before you report earnings. And it's because small-cap companies can't borrow fixed. They didn't get to borrow fixed long term when interest rates were zero during COVID. And so they have actually seen their interest expense go up a lot because of the Fed policies to go from about 0 to 5.5%.

If we only come back down to 4, then that's still a lot of interest expense to flow through into longer-term debt, longer-term interest finance costs for companies. So personally, I think the Fed should be coming down another whole percent, maybe even a little bit more just to get to neutral.

LIZ ANN: But will they?

PHIL: I don't think so. I mean, the market's not saying that, and usually the market knows a lot more than all of us separately.

And I think the reason the market's not saying it is a combination of risks that are out there. I don't personally think that the Fed being data-driven and looking at employment inflation is a good excuse. I think they're looking at the risk that tariffs are inflationary. I think they're looking at the fact that the government policies—I mean, we've been running a deficit on the fiscal side, so a government deficit of about 6% of GDP, which is not going to shrink. I don't even think with the Department of Government Efficiency being as efficient as it looks like it's being is going to help enough to reduce the government deficit. So we have, at some point, debt-to-GDP that maybe capital markets won't want to finance or at least won't want to finance at risk-free interest rates. So there's a possible credit risk aspect to it. And if we are spending this much, and our economy is growing this much, and wages seem to be growing faster than inflation at the moment, so consumer spending should keep growing, that's all actually positive for growth. And so either of those three explanations are good enough explanations for interest rates to stay higher. And I think that's why the market's pricing in 4%, not 3%.

LIZ ANN: Yeah, one more thread I'm going to pull from a macro perspective and then I want to get to the market, and we'll start with profit margins. But I think it was an important point to make about demographics, and this is where I want to tie in another policy thread that brings a lot of uncertainty, which is immigration and deportations and your perspective on the implications for the labor force in the United States, given that I think it's been four and a half years or so where pretty much all the growth in the U.S. labor force has been foreign born. Now, I've said that before, even on this show, and I've gotten comments, "No! You're wrong. It's not all illegals." I said, "That's not what I said." I said the labor force growth was foreign born. That's foreign born. It's not the same thing as saying illegal, but what are your thoughts on immigration policy and implications for labor force growth in the U.S.

PHIL: Yeah, so I mean, what's interesting when I go and talk to corporates that list on Nasdaq is a lot of the time they say that "We have an immigration problem," but what they say is "We can't get enough STEM qualified, like, engineers, scientists, lab techs, you know, chip-building, chip-designing people for the industry that we have here." Even Boeing and all of the airlines and the sophisticated engineering they have, and so people with that skill set they need to get visas for to get into the country. So I think that answers part of your response, which is we need really well-educated people to come in to fill the jobs that America has because we have a pretty high value-add industry set in America, so that's the first aspect of it, I guess, is we definitely need to still have skilled people coming in.

The deportation question, I think, is a little bit more interesting because it depends how it's done. And if you look at the numbers, maybe there's something like six to eight million people that are undocumented. And so if you try to deport all of them, just thinking about the number of plane trips that you're have to do, the actual work that's going to have to be done, the cost that's going to be incurred to put all those people into other countries is pretty phenomenal. It's a multi-year problem to solve. 

So I don't think any of the economists that I read are really expecting that to happen. If it's something much more minor where it's all the people that recently crossed the border that aren't working yet, and they put them on planes and send them back home, it's not going to change the workforce at all.

If they start to go into the agriculture sector, which apparently has a lot of undocumented immigrants, maybe some textiles businesses, construction, other sort of industries that the statistics say those people find jobs, and actually round people up and put them on planes, then you're to start to impact the workforce in those sectors. And what's interesting about that, if we think about COVID, the reason we had that second wave of inflation in COVID was it was wage inflation. And remember, at first we had quiet quitting, but then we had the great resignation. The great resignation was when there wasn't enough workers for the number of jobs because we were all starting to spend again. We were all starting to do our revenge travel and our revenge restaurants and our revenge entertainment spending. And there just wasn't enough people back in the workforce. And so the only way you could get people out of the manufacturing transport sector back into the services sector was to pay them more wages. And then the company across the road would pay even more wages again to move the person back across the road. And so if you look at the statistics, the people that quit, the people that were job switchers, saw their salaries going up at a rate almost double of everybody else.

So yes, everyone's salaries went up during that period where there was way too much demand for labor and not enough supply of labor, but the job switchers saw their salaries going up more. So long way to answer your question, which is if we deport too many people, I suspect we could create supply chain problems for labor in America where there just aren't enough workers to maybe keep doing the jobs that we need. I know there was an article this weekend saying if we go and round up farmers in the Midwest, we might not be able to get milk and eggs.

Which reminds me of one of my daughter's books, Farmer Brown. No milk and no eggs, what's he going to do? But in reality, it's a problem, right? We are going to need to eat and drink, and so we'd have to pay way more wages to attract people into those industries.

LIZ ANN: Right, which all else equal has an inflationary component to it. So I want to bring in the micro a little bit more now. And I think it's important that you discuss profit margins and the ability to maintain those, maybe not just specific to tariffs, but in general, and companies' tendencies, even back in 2018, to pass some of those costs on to consumers.

The outlook for earnings this year is largely predicated, or a consensus forecast is predicated, on profit margins being at or near a record. How likely do you think that is? Could that be one of the reasons why, even though fourth-quarter earnings season, which we're in the midst of now, getting toward the end, was a pretty decent earnings season, why you haven't seen a commensurate pop-up to estimates for 2025? Some of that is base effects, but are you concerned about the ability for companies to maintain these fairly lofty profit margin assumptions that are embedded in the outlook for 2025 earnings?

PHIL: Yeah, I mean, I could have said that two years ago and would have been wrong because companies have kept delivering profit margin growth. And you're right, we were at record levels then and we are at record levels now. I think one of the factors that kind of maybe makes the math of profit margins at the moment a little bit quirky is just how much spending there is on artificial intelligence. And you think about that kind of spending, it's like it's buying chips and putting them in factories that are running computer programs. There's not a lot of labor required.

And so those companies have quite good profit margins just because it's new technology, but also not much labor input. And so that increases productivity, increases profit margins for the whole, because there's so much of the spending and the revenue is coming from that space in the economy. So that looks like it's going to continue. I mean, I know that factoring the AI models is really the expensive part for the companies. And once we actually just start using it, it'll be cheaper, but it looks like we still have work to do to get AI models to be able to replace, I guess, replace humans and respond without hallucinations or errors. So I think the spending on AI looks like it's going to continue for a while at least. I mean, I kind of think of the early internet buzz where there was a lot of web pages that you could kind of shop on, but there really wasn't a delivery service. There wasn't like trust factors. There wasn't scores. And then all of a sudden, really what the internet did to productivity was join things together. It let you manage things electronically and take paperwork out of the process. And I think AI is going to be like that kind of revolution, too, where, you know, like when we hop in our car nowadays, and the maps just pop up, and the GPS takes us where we need to go. I think AI is going to start to help in some jobs just by solving problems without us needing to go into a whole lot of research. So it should increase productivity down the line as well. 

LIZ ANN: You mentioned the users of AI, and I think that's a really interesting story this year, especially in light of the news that came out of DeepSeek a few weeks ago, which seemed to have gotten pushed off the front pages a bit from the market's perspective just because of the uber focus on tariffs. What is your perspective on … are we now seeing a shift in terms of investor interest, not away from, but maybe a little bit more focused on who are the beneficiaries of this? Not just specifically the DeepSeek news and the cost aspect of it, but kind of the shift from all the focus being on the infrastructure and the enablers of AI into "How do companies across the spectrum of industries and sectors adopt AI for the benefit of growth of their company, profit margins maybe specifically, or productivity?"

PHIL: I don't feel like we're seeing it yet. I guess people are starting to talk about it, 'cause you just brought it up, and it's definitely something that people are asking me when I'm on stage talking about this as well. "Which companies are going to have the biggest productivity gains out of AI?" I don't think we know yet. I mean, I kind of think of AI a little bit like robots for the white-collar workforce or for the office floor, not the factory floor. So anybody that's got a big office full of people doing thinking and paperwork is probably a pretty good spot to think that there can be productivity gains. But then I think back to how the tech bubble kind of played out, and just because you could benefit from the internet didn't mean you actually made profit out of it. So it's going to be really interesting to see whether, like hypothetically, lawyers are one group that's theoretically going to be much more efficient with AI because you can ask it to create a document, and it'll do it very cleanly and consistently.

If every lawyer does that at once, then all their costs come down at once. So they don't earn as much revenue even if their profit margins stay the same. So it's going to be very interesting to see how it actually plays out. Maybe the consumer ends up being more of a winner because things just get a little bit more efficient and more productive.

LIZ ANN: You mentioned the spend on AI, and that's a big part of the, always part of the, discussion around the Magnificent Seven group of stocks and the circular nature of spending, and the numbers coming out from those companies on their spend are still quite lofty numbers. So I wanted to just, in that context, ask you more broadly about your thoughts on the Magnificent Seven and maybe tied into your thinking on concentration, and are we starting to see some of those pretty significant dispersion in how those stocks are performing work its way into maybe easing some of that concentration problem that was certainly evident in 2023 and 2024?

PHIL: Yeah, I mean, definitely it's causing dispersion in returns. So if you look at last year, almost all equity markets around the world were up, partly because interest rates are coming down, partly because all of the economies are starting to recover and grow, even slowly, but grow again. But actually, if you look at U.S. small cap, it performed pretty much in line with Europe and Asia.

The U.S. large-cap index outperformed significantly, and the Nasdaq 100 beat that as well over the last couple of years. And halfway through the year, someone showed me an index that was doing even better than the Nasdaq 100, and that was the Philly semiconductor index. And so I think that points to the fact it's not just the Mag Seven, but it really is the AI complex. Cause the Philly SOX index has a lot of chip makers and fab types of industry in it. So really, it's the spending is on AI specifically.

And I think that's the reason for the dispersion across the returns in the equity space right now. Whether that starts to filter down is interesting. Looking at the forecast of earnings, the interesting thing is the price/earnings multiples, so the valuation of those AI companies looks like it's stretched until they come in with earnings, and they actually do deliver growth with real revenues. And so the earnings goes up, and the P multiple keeps coming back down. So it's not like the tech bubble, which was a multiple expansion with no earnings growth. This has real learning growth behind it. The forecast going into this year are for that to moderate a little bit for the AI stocks, and for all of the other stocks in the S&P 500 to start to catch up. So it's broadening, which is a good thing, I think, because even if we do see some hiccups, or whether it's supply chain hiccups on the AI spend or just because the models are factored enough that people can start to use them, and the spending starts to normalize. I'm not saying it's going to drop. It's just going to slow down in the growth rate.

I think other companies can start to hold up the market because the earnings for them are all starting to increase as well. And then if we get lucky and interest rates come down, it looks like small cap could see some recovery as well. So that would be a broad-based recovery across the U.S. spectrum of earnings and profitability.

LIZ ANN: You know, speaking of small caps, you mentioned earlier in our conversation the issue with interest coverage and the pressure in general more on smaller companies that have higher levels of variable-rate debt, and there are more at the mercy of swings, particularly in longer-term interest rates. So is that a necessary ingredient, a move down in yields for small caps, maybe broadly? Now specifically, you can even go into small-cap indexes and look at the difference in performance between the high-interest-coverage stocks and low-interest-coverage stocks, but the move in yields that we've been seeing, how important is that for small caps, and how necessary is it for there to be less pressure on, say, the 10-year yield for small caps to do well in the aggregate?

PHIL: Yeah, so I guess the first thing is you're 100% right—it depends on the company, and some have more debt than others. So there's definitely companies that are less exposed to this problem. But if you look at the breakdown of fixed-to-variable financing, large-cap companies, very few of them have any variable-rate finance.

For small-cap companies, about a third of their finance is variable. And then if you look at the fixed financing, this year is OK. So I think if rates can come down by the end of this year, which was the original plan, right, six months ago, a lot of companies will be able to refinance it at quite lower rates. And it's really next year and the three years after that where there's, I guess you could call it, a wall of refinancing for the small-cap companies that do have fixed-rate debt. Large-cap companies, that happens more 2030 and on. 

So even like, looking at what happens next year and the year after for interest rates matters much more to small-cap than large-cap companies because they have refinancing of their fixed debt. There were some statistics last year that looked like a lot of companies that were refinancing were refinancing very short-term hoping rates would come down. And so the fact that they're holding up higher for longer I think is going to hurt them, but we can already see in like they would have refinanced at the highest rates. So we can already see in the interest expense. It's hurting them a lot if we look at that interest-expense-to-EBIT ratio for large cap, it's hardly budged. So it really shows that large-cap companies were able to refinance really low-term fixed-rate debt when interest rates on the Fed were close to zero, and they haven't really had to worry about interest expense that much. So I think on the small-cap side, like interest expense looks like their biggest problem. What's interesting is there's some surveys that come out that talk about "What's your biggest problem?" to small-cap companies, and interest expense is not on their radar.

What's on their radar is labor quality, the availability of skilled labor, the cost of skilled labor, and also inflation of their inputs. And so that's more like everything else we've been talking about. If tariffs happen, it's going to be more problematic, especially for a small-cap company that has a supply chain that's international. They've already seen the cost of their inputs go up more than 20% in the last few years, the cost of their labor go up about 25% in the last few years.

If they start to see shortages of labor, and they have to pay more, that's going to continue. If they have to pay tariffs on top of the products, that's going to make that more expensive as well. And that's actually what they say are their two biggest problems.

LIZ ANN: You mentioned earlier the higher value-add nature of our economy. I think that's an important point, especially as a preface to my question to you about valuations broadly. I think another important thing that you mentioned was the difference between sort of the AI era and the dot-com era, given the fact that momentum as a factor was very dominant in terms of performance in that late 1990s period, but the fundamental factor most highly correlated to it at the time, and to your point, was negative earnings versus now, momentum has been a high-performing factor, but you've got stronger fundamental factors moving alongside it. A lot of which reside in the Mag Seven type names, the AI-related names, strong top-line growth and strong bottom-line growth and ample cash flows.

So I think that that is an important differentiator, not to mention when you're a value-added economy, it sort of generally biases up the appropriate valuation afforded to the market broadly. So how do you think about valuation now? I think sometimes the analysis is a little too simplistic of comparing, say, a forward P/E now on the S&P 500 to its long-term trend or where it was at some other point.

But I think there has to be that adjustment for the value-added nature of our economy. So what are your thoughts on valuation in the current environment?

PHIL: Yeah, I mean, there's a really interesting pair of charts that I often show people, and one is the performance of the stock markets. So we talked about how small cap has gone OK, large cap has gone much better, and the Nasdaq 100's beat that a lot. If you draw the exact same chart but for earnings in those indexes, it looks the same. So you're 100% right—earnings is driving the returns this year, and the earnings do explain it. If we go back decades, what's really interesting is there's periods where the stock market gets ahead of earnings and periods where earnings get ahead of the stock market, but over multiple decades, earnings explains most of the price changes in the stock market. 

So I think earnings are really important. What you're asking is a little bit more granular, and it's almost like "Is the construction of the U.S. market different enough that we have more growthy stocks than other countries in the world?" And I think the answer there is absolutely yes at the moment, because Mag Seven stocks are all American stocks. There's not that many companies with the growth of earnings like we're seeing in those companies in other countries. Some of these diet drugs, Novo Nordisk is a European company. So there's spots where that's true in other countries in the world, but I guess America right now is kind of lucky because it has a big ecosystem of tech companies, probably thanks to the West Coast initially, but lots of tech companies building out this AI. We've got a lot of chip fabs that have been getting built the last four years. So we'll be able to manufacture our own chips pretty soon in scale in the U.S. So we're pretty well positioned to keep, I guess you could say, dominating that space. And because of that, the multiples in the U.S. market are always a little bit higher because we always have a more tech-y marketplace than other countries in the world, which are much more older companies, more value-based companies. I think that's definitely true that the U.S. market is constructed a little bit differently. So our P/E multiples, probably they are historically higher. It's a fact. But I think it's because of the companies that are in our index a little bit, too.

LIZ ANN: Let me ask a final question, sort of a sum-up question as you think about the landscape. Maybe ask for risks first and then opportunities second so we can end on a more positive note.

PHIL: I like that. I mean, the biggest risk is how the tariff war plays out. It's interesting talking to companies because they're not all as bearish as European economists who I heard from last week. So Europe is really nervous about tariffs completely killing … I mean, they have declining industrial production in Europe right now. Their economy is being held back because their manufacturing sector is weak, their productivity is weak, and they're worried that you put tariffs in place, and it creates a recession in Europe. In America, I think a lot of companies are like, "You know what, I'm dynamic. I can change things. I can still import goods. I can probably produce them in America if I use a whole lot of automation, almost as cheaply as I can get them from overseas, I'm just going to have to invest in it." And that was definitely the case in 2018 with some of the companies I was talking to, that they were able to onshore or nearshore and kind of fix for the problems of the initial tariffs. That of course means tariffs earn less money for the government, which doesn't fix our fiscal problems, but it does mean that companies can modify what they're doing to avoid increasing costs for us all that much. 

So the tariff, it's just uncertainty at the moment, but there's a chance that it really does slow down growth, or maybe the bigger risk is it caused companies to do nothing for a year while they wait to find out how everything falls, rather than they just get on with moving factories like they did in 2018. In terms of optimism, I mean, I still think in Europe, wages are starting to grow now because they have a slightly different employment system, but their wages are now growing faster than inflation. That should put more money in Europeans' pockets. The only reason that they haven't started spending is just, culturally, they seem to save when they get extra money. But if they can start to spend on European things, then I think they can lift the European economy up.

And so that's what the forecast is showing is just a broadening of the recovery of the economies around the world. The U.S. economy, because we've got a lot of people with low fixed-rate mortgages, the interest rate expense hasn't really affected our consumption, and the consumer is most of the reason our GDP is strong because with wages going up as well as not having to pay interest on mortgages, as well as a few other things, the consumer here is really strong, keep spending, and that's driving the GDP. And the other thing that's driving GDP is government spending. 

So net government spending, that deficit that we talked about as being a potential problem 10 years from now, is actually helping the economy right now because it's just increasing spending in construction and in other areas of the economy and keeping the employment rate strong as well. So one of the things I look at is the rate of layoffs, which is pretty close to decade lows. And while that's true, I think that the Sahm Rule, which worries about unemployment picking up and people all pulling their hands and putting them in the pockets and not spending anymore, is probably off to the side. So when we have a strong enough economy that we don't have layoffs, which seems to be where we are with wages increasing, we should theoretically still see strong growth this year.

LIZ ANN: Yeah, and thanks for taking us to the close here on a positive note. It's also interesting that you mentioned Claudia Sahm and the Sahm Rule maybe being pushed aside. We've had Claudia on as a guest on this podcast, and she was actually one of the first people to say, "Hey, I'm not sure if my rule triggering is actually applicable this time for a variety of reasons." So it was interesting that you mentioned that, but thank you so much for such a wide-reaching conversation. I feel like we covered a lot. I really enjoyed this, and we really appreciate you coming on, Phil.

PHIL: Yeah, thanks very much for having me. It's been great.

KATHY: So Liz Ann, we have another solid dose of economic data ahead of us next week. What are you going to be watching?

LIZ ANN: The big one is the Personal Consumption Expenditures price index. That's the Fed's preferred measure of inflation and particularly important given that we had a little bit of a hot reading on the Consumer Price Index. So I think that is probably the big one. We get some regional Fed data. We do get more housing data. We get home prices, pending home sales, building permits, which is a key coincident indicator. We get the next update on GDP, gross domestic product. We also get durable goods and cap goods. And then weekly claims. I think it's going to be interesting to start to look for the impact on claims from some of the federal government employee layoffs, at least those that did not take some sort of severance. So what's on your radar, Kathy?

KATHY: Well, all that data will be important. But the one thing I'm kind of anxiously awaiting is a speech by Dallas Fed President Lorie Logan. She'll actually be in London, but she's going to give a speech. And Logan had previously worked at the New York Fed running their trading desk. This is where the things get executed for the Fed is on that desk. And she is sort of the spokesperson for policy effects of the various maneuvers that the Fed has been doing, whether it's quantitative tightening or aiming at an ample reserves position. I mean, she really understands the plumbing of the Federal Reserve system, and I'm going to be curious to see if she comes out with any new perspective, new information about any changes that may be awaiting us from the Fed's management of the balance sheet or management of reserves. This has a real big impact on the banking system and in the Treasury market. So I'm anxiously waiting to hear what she has to say. She's always got very precise and very clear kind of messaging. So it's going to be interesting.

So that's it for us this week. Thanks for listening. As always, you can keep up with us in real time on social media. I'm @KathyJones—that's Kathy with a K—on X and LinkedIn. And you can read all of our written reports, including charts and graphs, at schwab.com/learn.

LIZ ANN: And I'm @LizAnnSonders on X and LinkedIn. Those are the only platforms I'm active on. So make sure you're actually following me and not the rash of imposters I've had for quite some time. And we are really grateful for everyone who has left us feedback on Apple Podcasts or Spotify. So thank you for taking the time to say thanks to us, and please consider telling a friend about the show. We will be back with an exciting new episode next week. 

For important disclosures, see the show notes or visit schwab.com/OnInvesting, where you can also find the transcript.